Confidence in U.S. bonds slipped well before threat of downgrade

The threat of the first downgrade of U.S. government debt - for decades considered the safest investment in the world - came as a jolt to some in Washington last week, but financial markets foreshadowed the move for months.

Many global investors already essentially downgraded the U.S. by voting with their feet and increasingly shunning U.S. bonds.

Among the strongest signs that the U.S. was losing its luster among the world’s investors has been the steady decline of the U.S. dollar against most other currencies as foreign investors, worried about burgeoning U.S. budget deficits, sought ways to avoid putting their cash in dollars and U.S. government obligations.

China and other major emerging countries that have invested most of their trillions of dollars in cash reserves in U.S. Treasurys for months have been seeking to diversify out of U.S. holdings on the expectation that the dollar will continue to fall while budget deficits continue to swell into uncharted territory of more than $1 trillion a year.

China, Treasury’s largest foreign investor, has made no secret of its unhappiness with the precarious fiscal situation and heeded the advice of a little-known Chinese rating agency that downgraded the U.S. from AAA to A a year ago.

The price of gold - considered the ultimate safe haven for investors who worry about the deterioration of U.S. finances - has soared in the past year and reached record highs of more than $1,500 an ounce last week after Standard & Poor’s Corp. became the first Wall Street agency to warn that the U.S. might lose its top AAA credit rating.

Perhaps the markets raised the biggest red flag this year when the world’s largest bond fund, Pimco, announced that it was dumping its Treasury holdings out of concern that the U.S. Congress and Obama administration are nowhere close to facing the facts about the need to rein in federal benefits programs and raise taxes.

“Unless entitlements are substantially reformed, the U.S. will likely default on its debt” in a subtle and disguised way, said Pimco chief William H. Gross.

Mr. Gross said he doesn’t expect the U.S. to default outright on its obligations and stop making payments on the debt. Rather, he warned of a kind of “backdoor” default process already under way, whereby the U.S. Federal Reserve and Treasury spur inflation through devaluation of the dollar to enable the government to “inflate” its way out of the debt. At the same time, the Fed is holding interest rates at artificially low levels that do not compensate bondholders for the increase in inflation.

While many in Washington have feared that China or Japan might one day stop buying U.S. Treasury bonds, China has diversified into other countries’ bonds gradually to avoid impairing the value of China’s massive U.S. holdings.

It was the sudden exit of Pimco - one of the major investment funds in the U.S. - that should have set off alarm bells in Congress, analysts say.

“Pimco out of Treasurys? That’s like McDonald’s deciding not to buy any more hamburger meat,” said economic commentator Gonzalo Lira.

S&P’s warning about a downgrade April 18 only “highlighted a fact that everybody already knows,” he said. “Treasurys are nowhere near as gilded as people would like to believe.”

“We shouldn’t be surprised at the concerns” raised by S&P, said Carmen Reinhart, senior fellow at the Peterson Institute, noting that investors worldwide have been signaling concern about the deteriorating U.S. fiscal situation for a long while.

With deficits ranging around $1.5 trillion recently and projected to stay nearly that high for years to come, the fast-growing U.S. debt burden is at the “extreme end of the spectrum” among advanced countries, she said.